You can never eradicate systemic risk, which collapses the entire financial system, but only reduce it in the stock market. However it’s up to different regulators to decide as to what level of risk they are comfortable in taking, share market participants say.
“Given the levels the markets have gone up to, the lack of capital adequacy in Sri Lanka's brokers and the overall exposure to the stock market from the banks, both the Securities and Exchange Commission (SEC) and the Central Bank have done a decent job," Deshan Pushparajah, Manager Corporate Finance, Capital Alliance told the Business Times.
Lessons learnt – Bangladesh
He added that provided margin trading licenses are provided to related companies of the brokers (which will meet requisite capital adequacy standards) there will be little effect to the market itself. "Again, what level of risk the regulator wishes to take, changes from country to country, but given the causes of the current global economic crisis plus the ever occurring bubbles in emerging markets (recent Bangladesh being a good example) you can hardly blame them for being concerned," he stressed.
He noted that regulator directions have reduced systematic risk (by requiring all broking houses to clear its uncovered debt by 31st December 2011 and ensuring only licensed margin providers would provide financing for share transactions) though capping retail buoyancy in the short run.
Mr. Pushparajah noted that foreign portfolio investors who entered the market during the past 36 months (or earlier) were seen booking their profits with all rationality despite the strong positive outlook. Hitherto the ability for the market to sustain (while growing by 6.1% year to date) and absorb the foreign selling justifies analyst projection of a much buoyant market when both foreign portfolio investors and local institutional investors become bullish in the future.
Jaliya Wijeratne, Director Institutional and Foreign Trades NWS Holdings said that systemic risk, which collapses the entire financial system or an entire market as a whole as opposed to one entity or group or sector, happens mainly due to all markets and segments being related and having linkages to each other. This was clearly seen when the subprime mortgage lending crisis occurred in the USA how all other markets around the world was affected.
As to how to reduce systemic risk, he went to explain it from two points of view - the regulatory point of view as well as how the investors’ see it.
Regulars’ see it
The main reason for systemic risk to exist is the risk of default occurring in one market and how it affects the collapse of all other related markets. “This happens when people are allowed to spend more than they can actually afford to spend. This was the main cause of the sub-prime crisis as well. Therefore these borrowers start defaulting on their loan payments which will affect the banks and in turn affect their lenders and will have a ripple effect on the whole system and cause the whole system to crash,” Mr. Wijeratne said.
He noted that to avoid the market from crashing in the first place preventive action is taken by the regulators and they do this by tightening monetary policy and increasing interest rates. “When this happens, borrowers will not be able to spend their money lavishly as borrowing will be more expensive for them,” he said, while also noting that this cannot be used when the market has crashed. He added that increasing the interest rate at that moment will only worsen the impact of the crisis because everyone will be selling and no one will be able to afford the lending rates to buy shares which are being sold at low rates. Monetary policy has to be loosened and interest rates dropped for the public to be able to afford buying the goods.
Investor point of view
Mr. Wijeratne says that the lesson to investors is not to put all their eggs in one basket. Diversified holding equal portions in money market, share market, commodity market and government bills and bonds would be the safest option. Radhika Ratnayake, Research Analyst NWS Holdings noted that systematic risk is a risk inherent to the entire market. While, many risks can be reduced in four main ways; namely by avoidance, diversification, transferring and hedging, he says that when it comes to systematic risk, it is difficult to avoid as it is a risk inherent to the entire market.
“Having the right regulations is the best way to reduce systematic risk. One of the main reasons for regulations in the market is to reduce systematic risk and governments and institutions around the world try to put policies and rules to safeguard the interests of the market as a whole and its participants,” he said, adding that the SEC has to learn from other developed markets and has to take timely actions to prevent local markets facing any unnecessary adversities.
Discussing the range of views on the SEC's decision to impose the restrictions on lending, many analysts said that the regulator took the right decision. “Our market was overheated with high valuations by the end of 2010 (despite the growing earnings) and especially the market rallies that were seen during the period were fuelled by such lending. As you know there are lot of inter linkages and inter dependencies in the market and failure of one entity can cause a cascading failure which could bring down the entire system. So I do think that SEC's decision was a timely measure,” Mr. Ratnayaka added.
Long term sustainability
But some looked at it in an adverse way as the curbs on lending were partly responsible for the market to fall in the recent period. “Apart from this, low foreign participation and the low activity of institutional investors who chose to stay on the sidelines also contributed to the downturn. Nevertheless it led to a much needed correction in the market. So people have to think about the long term sustainability of our market rather than complaining about the negative impact that it had in the short run,” an analyst said.
He said that the SEC has to introduce regulations from time to time to address the needs of the market. “Apart from that, developing our capital markets with improved infrastructure, liquidity, new products, widening issuer and investor base would help our market sustainability,” he said.
Dhanushka Samarasinghe, Director TKS Holdings noted that the undue credit exposure in the local market has increased the inherent systematic risk. “It was a most welcome move by the SEC to implement stricter controls for brokers providing credit for their clients. Presently financing for share purchases is only allowed through licensed margin providers though existing credit exposure (provided through broking houses) is still not zeroed in full, contrary to earlier guidelines by the SEC,” he said.
He noted that banning the provision of credit by brokers is a good move to mitigate the risk within the capital market system, though he wasn’t in favour of the repetitive extensions on the deadline which now stands at 31st Dec 2011. “It would have been better for the regulator to stick with the previously stipulated deadline of 30 June 2011 and clear all debtors with the brokering houses. Such a move would have given consistency and predictability while improving the confidence amongst non-speculative professional market participants,” he said.
Mr. Samarasinghe said that while critics can argue such clearing of debtors would result with a market correction (though even without this the market has continuously dipped during the past three weeks) it is a fact of life we need to realize sooner than later, so the systematic risk in the system can be eliminated soon.
To the investor: Four ways to avoid risk
1. Diversification – Diversifying the investor’s portfolio will only reduce the sector risks in the market. But total market risk is still inherent in his/her portfolio. Therefore if the market still crashes there would be no point of the diversification as all shares in the portfolio would be affected by the systemic risk.
2. Hedging – hedging will also have the same impact as above as it is only involved with a particular segment (money market etc.) therefore hedging also does not help when it comes to reducing systemic risks
3. Transfer the risk – this is mainly done through insurance companies. Insurance companies will bear any risk as long as they are paid a good premium, which will give them good operating cash flow. In the case of a crisis, and the insurance company fails it will file for bankruptcy and will hide under limited liability. Therefore insurance holders are worst off.
4. Avoidance – this seems to be the only way to avoid systemic risk from an investor point of view. This is by moving the investors' entire portfolio into an unrelated or negatively correlated market altogether. The best example for this is moving away from money and the share market to the commodity market. Investing in gold is a better option.
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